Messari: A Detailed Explanation of Goldfinch's Operating Mechanism, Economic Model, and Risks

Original Author: Kunal Goel

Original Title: 《Goldfinch Finance - Let's Get Real》

Compilation: Beam, H.Forest Ventures

Introduction: Goldfinch is a decentralized protocol that links real-world lending needs, primarily providing USDC lending services to lending enterprises such as debt funds and fintech companies. The author provides a detailed analysis and explanation of the operational mechanism, market demand, financing background, token model, and risk points of the Goldfinch project.

The Goldfinch project has a strong financing background, a reasonably designed mechanism, and a large expected market space. Since its launch, the price of the token has experienced significant corrections, making it worthy of attention.

The following is the main text:

So far, crypto lending has been constrained by two main limitations. First, the pool of borrowers is limited, primarily composed of cryptocurrency natives who speculate and trade in the crypto market through borrowing. This means that the potential demand for loans (reflected in interest rates) largely depends on market conditions. When the market is booming, the demand for lending increases, raising interest rates. However, when market prospects are weak, loan demand and yields decline.

Figure 1 The lending behavior is strongly correlated with market sentiment

The second limitation of crypto loans is that they must be over-collateralized. Without an identity system or credit scoring on-chain, we cannot expect borrowers to repay loans if they are provided loans without sufficient collateral.

This applies to most crypto lending markets, with a few exceptions, such as Iron Bank and Maple Finance, which lend to approved crypto protocols and institutional participants, as well as Aave flash loans that must be repaid within the same block.

Goldfinch Finance provides zero-collateral loans to approved entities in the real world, thereby addressing the two limitations of crypto lending protocols. By offering loans to borrowers outside of cryptocurrency, Goldfinch brings the returns of real-world businesses into the crypto ecosystem. It is able to tap into a whole new pool of borrowers and generate returns that are completely unrelated to the crypto market.

Additionally, by adopting a unique protocol design and lending only to approved entities rather than anonymous wallets, Goldfinch can provide loans that do not require over-collateralization. The protocol design aligns individual incentives with the larger whole and rewards active participants and risk-takers.

Protocol Design

Goldfinch serves lending enterprises such as debt funds and fintech companies by providing them with USDC credit lines, which they can convert into fiat currency and further deploy to borrowers.

Goldfinch has a unique design that enables it to offer zero-collateral loans in the real world. To better understand it, let's explore the lending process.

1. Before borrowers can apply for loans, they must receive approval from the protocol's decentralized auditors. Auditors are independent entities that must stake governance tokens (GFI) to have the opportunity to verify borrowers in exchange for rewards. Auditors only assess whether the borrower is who they claim to be, without evaluating their creditworthiness. Currently, the auditing system is not yet live, and core contributors approve borrowers.
2. Once approved by the auditors, borrowers present loan terms to backers. These terms may include details such as the amount sought, loan duration, interest rate, background of the borrower, and how the funds will be used.
3. Backers assess the borrower's credibility and, if they agree to the terms, can choose to provide the junior capital. The junior portion is the high-risk pool that is first written down in the event of a default. Therefore, it is also referred to as "first-loss capital."
4. The senior pool, collected from liquidity providers, then allocates funds to the senior portion. The senior pool can lend out several times the amount of the junior portion. The senior portion is a low-risk pool. It receives payments first and is only written down if the junior portion cannot fully cover a default. To compensate the junior portion's backers for their additional risk and the work of assessing the borrower, they receive 20% of the returns earned by the senior pool.
5. Once the senior pool has completed its allocation, the loan process is complete, and the borrower can use the funds.

Figure 2

Anti-Fraud

Since Goldfinch Finance provides under-collateralized loans, borrowers have an incentive to attempt to defraud lenders. Backers conduct their own due diligence and want to understand the risks at the time of lending.

However, the senior pool, composed of passive lender funds, must be protected by the protocol design and incentive structure. Therefore, the protocol employs multiple checks during the lending process to minimize fraud risk.

The first layer of protection is that all borrowers in Goldfinch are named entities that exist in the real world. This alone distinguishes it from other crypto protocols with anonymous borrowers.

This incentivizes borrowers to act in good faith to maintain their reputation and credit record. Backers can also independently require borrowers to sign agreements to have legal recourse in the event of fraud.

Since borrowers must receive auditor approval before submitting loan requests, the fraud risk is further reduced. A random group of nine auditors is selected from the auditor pool to minimize the risk of collusion.

Approval is also obtained through an absolute majority, requiring at least six "yes" votes and no more than one "no" vote to allow the borrower access to the senior pool. Auditors must stake GFI, providing them with the incentive to act in the best interest of the protocol.

The consensus mechanism-like proof of stake also encourages their honesty, as auditors voting against the majority will have their stakes reduced. Each auditor must also pass a KYC check called a Unique Identity (UID) to prevent Sybil attacks.

Additionally, backers help reduce fraud risk by acting as credit analysts, assessing the borrower's credibility and whether the terms match the risks. Since they are responsible for compensating capital in the event of losses, this incentivizes them to act cautiously in their analysis.

The senior pool uses a leverage model that considers the distribution of backers, so borrowers supported by a large number of backers receive a larger allocation from the senior pool. Backers must also have a UID to prevent Sybil attacks.

Goldfinch also encourages auditors and backers to interact directly with borrowers through real-world communication methods such as chats, video calls, and AMAs during their checks.

Typically, crypto lending protocols do not require analyzing borrowers' creditworthiness. This is because their loans are over-collateralized, and automatic liquidation protects the protocol from write-downs if the collateral ratio falls below the minimum threshold. In traditional finance, lenders can access borrowers' credit records to assess their risk profile and make informed decisions with better terms. Goldfinch functions more like a bank in traditional finance but has decentralized auditors, lenders, and credit analyst pools, with incentives designed to act in the best interest of the protocol.

GFI Token

The GFI token is the governance token of the protocol managed by GFI holders in the community DAO. Holders vote to adjust various parameters of the protocol. For example, the community DAO can upgrade smart contracts, set and change reward structures, and pause the protocol in emergencies.

GFI plays a role in the protocol through the auditor staking/reduction mechanism. It also provides incentives for all participants. Currently, the protocol is running a liquidity mining program for lenders, with the APY of the senior pool increasing by over 25%, and the APY of the support pool lending USDC increasing by 40-50%. In the future, borrowers who fully repay their loans may also receive GFI tokens as incentives.

GFI also accumulates value through the protocol's revenue model. The protocol retains 10% of all interest payments in its reserves. Additionally, any redemptions from the senior pool incur a 0.5% fee, which is also added to the protocol treasury. The community DAO has full control over the treasury funds and can use them as it sees fit to benefit its members. In the past 30 days, the protocol has earned approximately $81,000 in fees.

Figure 3

Goldfinch has raised $37 million in three rounds of funding from large crypto venture funds such as a16z and Coinbase Ventures, as well as angel funds like Balaji Srinivasan, Ryan Selkis, and Tarun Chitra. The fixed supply of the GFI token is 114,285,714, but the DAO may add inflation factors later to incentivize future contributors.

Figure 4

Current Status

Borrowers on Goldfinch Finance are the enterprises themselves providing loans to end borrowers or debt funds lending to loan enterprises. Goldfinch collaborates with companies in different jurisdictions to access a wide range of end borrowers. So far, risk exposure has primarily concentrated in developing economies in Asia, Africa, and South America. However, recently, the US debt fund Stratos, with a 100% payment record, applied for a $20 million credit line. High-quality borrowers with favorable terms like this are crucial for the success of the protocol.

Figure 5

The protocol's TVL and outstanding loans are steadily growing. The current TVL is $88 million, having increased by 30% in the past 30 days. Most of the funds ($79 million) are locked in the senior funding pool. Outstanding loans have remained stable at $39 million this month. Three pools seeking to raise $40 million are currently open, which will facilitate loan growth.

Figure 6

Goldfinch offers the highest yield on USDC in cryptocurrency. Goldfinch's borrowers pay interest rates of 10-12%. Goldfinch can lend at such rates for two reasons. First, borrowers are willing to pay higher interest rates for under-collateralized loans. Second, due to its global operations, it can lend to businesses in developing countries where local rates for zero-collateral loans may be higher.

High borrowing rates allow backers to continuously earn yields of 15-18%, including an additional 20% return from the senior pool. The liquidity mining program further boosts their yields, bringing the total APY to over 40% at current prices.

At the current 40% utilization rate, the base yield of the senior pool is about 5%. If we include the incentives from the liquidity mining program, the boosted APY exceeds 25%. As utilization increases, the sustainable yield of the senior pool is expected to improve. The sought-after $40 million loan will raise utilization to about 90%. ++According to ongoing improvement proposals++, the utilization will also increase as the leverage ratio rises from 3x to 4x.

Challenges

The protocol is unique, and so are its challenges. The good news is that the protocol is not the result of smart contract innovation, so the risks associated with smart contracts are limited. However, its other risks are magnified as a result.

Credit Risk

Credit risk is the most critical risk for Goldfinch. Although it has an incentive structure that minimizes fraud risk, it still requires a certain degree of trust, unlike fully collateralized lending protocols. Additionally, unforeseen circumstances, as seen in the past two years, may lead to borrowers being unable to pay, even without fraud. If defaults occur in the senior pool, it may undermine lenders' confidence in the protocol's ability to mitigate risks. To paraphrase Uncle Ben, "With great rewards come great risks."

Regulatory Risk

Goldfinch also faces greater regulatory risks. Although its identity system does not include US participants, Goldfinch may still face stricter regulatory scrutiny in other jurisdictions due to its dealings with companies in the real world.

Expansion and Adoption

Goldfinch Finance may also face challenges in expansion and adoption. Unlike other lending protocols in cryptocurrency, Goldfinch Finance cannot simply achieve growth by subsidizing cheap loans through the protocol. It must find high-quality borrowers in the real world. However, this allows the protocol to resist forks and vampire attacks, as its network effects exist in the real world.

Sustained Incentives

Backers and auditors play an important role in executing the protocol by conducting due diligence on borrowers. Their work is complex, requiring analysis of different types of borrowers with unique risks from various jurisdictions. The protocol must keep them engaged by continuously incentivizing them. If the protocol's generated returns are insufficient, it may need to compensate through token inflation.

Conclusion

Goldfinch claims it is bringing "crypto loans into the real world," but from the perspective of cryptocurrency natives, it is bringing real-world returns to cryptocurrency. It goes without saying that providing zero-collateral loans that match the vast amount of crypto capital seeking returns with global demand presents a tremendous opportunity. However, it must adhere to the rules of traditional finance, balancing growth and risk. Goldfinch represents a significant step forward in the evolution of decentralized finance, linking the real world with cryptocurrency.

Translator's Note:

Linking real-world financial needs has been a direction explored by DEFI projects, such as MakerDAO incorporating real assets into collateral and Centrifuge striving to create diversified asset-backed pools to provide greater liquidity for real assets. In this sense, they all serve as a kind of "cross-chain bridge," continuously expanding the boundaries of blockchain alongside Goldfinch. Goldfinch functions more like a bank for DeFi, but its operations are decentralized, and its clients are not permissionless. Therefore, it involves more counterparty trading risks and regulatory and legal risks compared to typical DeFi projects.

However, the stars and the sea will eventually have their moment of breaking boundaries, perhaps starting not from Centrifuge, but from Goldfinch.